Markets for Inflation‐Indexed Bonds as Mechanisms for Efficient Monetary Policy

21 Pages Posted: 14 Sep 2015

See all articles by Christian-Oliver Ewald

Christian-Oliver Ewald

University of Glasgow; Høgskole i Innlandet

Johannes Geissler

University of St. Andrews - School of Economics and Finance

Date Written: October 2015

Abstract

We consider a continuous‐time framework featuring a central bank, private agents, and a financial market. The central bank's objective is to maximize a functional, which measures the classical trade‐off between output and inflation over time plus income from the sales of inflation‐indexed bonds minus payments for the liabilities that the inflation‐indexed bonds produce at maturity. Private agents are assumed to have adaptive expectations. The financial market is modeled in continuous‐time Black–Scholes–Merton style and financial agents are averse against inflation risk, attaching an inflation risk premium to nominal bonds. Following this route, we explain demand for inflation‐indexed securities on the financial market from a no‐arbitrage assumption and derive pricing formulas for inflation‐linked bonds and calls, which lead to a supply‐demand equilibrium. Furthermore, we study the consequences that the sales of inflation‐indexed securities have on the observed inflation rate and price level. Similar to the study of Walsh, we find that the inflationary bias is significantly reduced, and hence that markets for inflation‐indexed bonds provide a mechanism to reduce inflationary bias and increase central bank's credibility.

Keywords: monetary policy, inflationary bias, mechanisms, inflation‐indexed securities

Suggested Citation

Ewald, Christian-Oliver and Geissler, Johannes, Markets for Inflation‐Indexed Bonds as Mechanisms for Efficient Monetary Policy (October 2015). Mathematical Finance, Vol. 25, Issue 4, pp. 869-889, 2015, Available at SSRN: https://ssrn.com/abstract=2659383 or http://dx.doi.org/10.1111/mafi.12039

Christian-Oliver Ewald (Contact Author)

University of Glasgow ( email )

Adam Smith Building
Glasgow, Scotland G12 8RT
United Kingdom

Høgskole i Innlandet ( email )

Lillehammer, 2624
Norway

Johannes Geissler

University of St. Andrews - School of Economics and Finance ( email )

The Scores, Castlecliff
St. Andrews, Fife KY16 8RD
United Kingdom

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